Differential Voting Rights

I. Meaning:

Those investors who are interested in getting goods returns from the stocks rather than holding more stocks, DVR is good option for them. That's why many companies nowadays offer investors the option to earn a little more from a stock in exchange for sacrificing a few rights they rarely exercise. These shares, called differential voting right, or DVR. These are ideal for small shareholders as they rarely exercise their voting rights. They buy shares only to make money and so happily give away voting rights in favour of those who have management control.

DVR are like ordinary equity shares but with differential voting rights and either carry less than one voting right per share, or more than one voting right per share. However, this concession on the voting rights is compensated by the prospect of earning dividend at a higher rate and vice versa.

For instance, the holders of Tata Motors' DVR shares can cast one vote for every 10 shares held. However, they get 5% more dividend than ordinary shareholders. On 18th July 2012, the company gave Rs 4.10 a share as dividend to DVR holders and Rs 4 a share to ordinary shareholders.

II. Introduction of DVR:

• Initially, there was no provision for issuing DVR Shares under the erstwhile Companies Act, 1956. However, vide Companies (Amendment) Act, 2000, Section 86 of the Companies Act, 1956 was amended to include shares having differential rights as to dividend, voting or otherwise, as equity shares. Subsequently, after the introduction of Companies Act, 2013, provisions towards the DVR Shares have governed by Section 43 of the Companies Act, 2013 read with Rule 4 of the Companies (Share Capital and Debenture) Rules, 2014 (“Rules”).
• The main reason behind introducing DVR is to protect promoters’ interest in the Company. The concept of DVRs is letting promoter retain control over the company without dilution of rights, by allowing shares with superior voting rights (SR) or lower or fractional voting rights to public investor. The aim of limiting voting rights is preventing hostile takeovers by separating economic interests and voting rights.

III. Important Amendments in DVR Rules:

The government relaxed the important norms for issue of DVR Shares on 16th August, 2019, vide Companies (Share Capital and Debenture) Amendment Rules, 2019 which are as follows:

• The government removed the requirement of distributable profits for three (3) years for a company to be eligible to issue DVR Shares.
• The limit of maximum DVR Shares that can be issued by a company was revised from “Twenty-Six percent (26%) of the total post issue paid-up equity share capital” to “Seventy-Four percent (74%) of total voting power”.
• On June 2019, SEBI also released a Framework for Issuance of Differential Voting Rights Shares for (a) companies whose equity shares are already listed on stock exchanges and (b) companies with equity shares not hitherto listed but proposed to be offered to the public.
• Section 47 (deals with Voting Rights) is not applicable to Private Companies where memorandum or articles of association of the private company so provides.

IV Significance & Features of DVR:

• By issuing DVRs, the startups and Indian companies attract global investors and gain access to cutting-edge technology development and innovation undertaken by them.
• The DVRs will enable the promoters of Indian companies to retain control while raising equity capital from global investors and create a long-term value for shareholders and the company’s growth.
• DVR Shares offer a better rate of dividend than other equity shares. This is beneficial for those strategic investors who are primarily interested in the returns, without getting involved in the management and affairs of the company.
• Promoters could pursue their idiosyncratic dreams, especially in technology or intellectually driven businesses, without interference from other shareholders. The very format of company has at its roots the idea of risk-taking business without the fear of person ruin in case of failure. DVR concept takes this salutary protection further forward and provides protection to the venturesome promoters not only from the consequences of failure but also the assurance of continuing benefits from success, without someone else snatching it away at completion after all hard work had been put in.
• Many out of box business ideas, especially in the technology-based areas, start with relatively small capital based and when successful require larger infusion of funds. If the promoters cannot proportionately contribute to the additional equity, any issue to the outside investors will be fraught with the risk of control loss.
• Apart from voting rights, a shareholder will get all other rights intact such as bonus shares, right share issue, etc.
• There is a major risk of the DVR Share structure making the corporate governance standards in the company less transparent and also leading to potential oppression of minority shareholders.
• Since DVR Shares are able to separate economic interests with voting rights, promoters are able to exercise greater control over the company even when other investors have contributed more capital. Consequently, this prevents hostile takeovers.
• Due to relatively low popularity, trading volume of listed DVR Shares is generally lower in comparison to the ordinary shares of the company and also, the DVR Shares are traded at a lower price thus, the liquidity of DVR Shares has not been good.

V. Conditions to be fulfilled Before issue of DVR:

The companies issuing equity shares with differential rights under Section 43(2) of the Companies Act, 2013 read with the Companies (Share Capital and Debentures) Rules, 2014, have to fulfil the following conditions-

• The Articles of Association (AOA) of a company should provide for the issue of equity shares with differential voting rights.
• The company must obtain approval from the shareholders by passing an ordinary resolution in the general meeting.
• There should be no default by the company in filing its financial statements or annual returns for the last three financial years preceding the financial year of the issue of the DVRs.
• The company has no subsisting default in the payment of the dividend on preference shares, repayment of any term loan from a public financial institution or State level financial institution or scheduled bank that has become repayable or interest payable thereon, payment of dues with respect to statutory payments relating to its employees to any authority or crediting the amount in Investor Education and Protection Fund to the Central Government.

However, the company may issue DVR Shares upon expiry of five years from the end of the financial year in which the default mentioned above were made good.

• In case the company is listed, the issue of differential shares should be approved by postal ballot.
• There should be no default by the company in the redemption of its debentures or preference shares which are due for redemption and payment of any statutory dues of its employees.
• The Company has not been penalized by Court or Tribunal during the last three years of any offence under the Reserve Bank of India Act, 1934, the Securities and Exchange Board of India Act, 1992, the Securities Contracts Regulation Act, 1956, the Foreign Exchange Management Act, 1999 or any other special Act, under which such companies being regulated by sectoral regulators etc.,
• The voting power in respect of shares with differential rights of the company shall not exceed 74% on post-listing of shares.
• The company shall not convert its existing equity share capital with voting rights into equity share capital carrying differential voting rights and vice versa.
• The holders of the equity shares with DVRs shall enjoy all other rights such as bonus shares, rights shares, etc. which the holders of equity shares are entitled to, subject to the differential rights with which such shares have been issued.
• The Board of Directors shall, inter alia, disclose in the Board’s Report regarding issue of DVR, if any. Further, Explanatory Statement or Postal Ballot should contain details regarding DVR.

VI. DVRs Elsewhere in World Wide:

Internationally many countries such as the United States of America, Canada, Hong Kong, Singapore etc. allow issuance or listing of Dual Class Shares ("DCS") which are similar to DVRs. Countries such as United Kingdom, Australia, Spain, Germany and China do not permit DCS to be listed. The DCS issued in these countries can either have superior voting rights or other economic rights such as dividend. The companies like Google, Facebook, Snapchat and Alibaba have issued DCS. SEBI seems to have sought features for issuance and listing of DCS from across jurisdictions to permit the issue of DVRs in India. While the United States of America does not permit entities, which are once listed to implement the DCS structure, there is no requirement to have a sunset period i.e. a period within which the DCS will be converted into ordinary shares. In Hong Kong, only innovative issuers / biotech companies are permitted to issue DCS and the beneficiaries of these shares should play an active executive role in the business, should have contributed materially to the growth of the business and should be a director on the board at the time of the initial public offering. The DCS issued in Singapore are also locked in for a period of 12 months post listing.

VII. Valuation and Tax Aspect:

• Valuation of Shares: Section 56(2)(viib) of the Income Tax Act, 1961 applies to all types of shares i.e. equity and preference. The assessee has all the rights to choose a method i.e., NAV Method (Book Value) or Discounted Cash Flow (DCF) Method. Any of the methods prescribed do not consider adjustment for specific situations e.g., when equity shares are issued with differential voting rights.

Further same transaction of issue of shares may require a valuation to be carried by more than one valuer. e.g., under the Companies Act, 2013 valuation for the purpose of issue of shares is required to be carried by the registered valuer. In case, shares are valued using the DCF method than under the income tax provisions, such report is required to be issued by a merchant banker.

• Taxation: Allocation of the value of the enterprise, which is a function of economic and control rights, can vary significantly across the various class of shares. Presently Rule 11UA (1)(c)(b) or 11UA (1)(c)(c) does not explicitly provide an adjustment to address the value allocation across the various stock class. Hence, the equity value is distributed on a pro-rata basis across all the equity stock class, and there is a possibility that the value of a specific stock class determined is lower than the fair value adjusted for such differential voting rights.

Similarly, there could be structures which offer significantly higher dividends to a specific class of equity share. While, by utilising a dividend discount model (assuming a simplistic scenario), it would be possible to determine the value of different classes, the extant rule 11UA may not uncover the veil on value allocation. The rule could thus be exposed to transactions which bypass test of inadequate consideration.

Furthermore, there are companies which offer a higher dividend to compensate for the loss of control to the shareholders. The net effect is that the allocation of value among share classes will widen the schism in the meaning of fair value under rule-based valuations and commercial transactions unless the tax rules are updated to reflect the changing investment landscape.

• Downside: The gap in the methodology may work to the advantage of some share class, a reverse situation could be where a share class controls only 10% but represents 90% of the paid-up value, which can lead to a distraught scenario for the shareholder holding this class of shares.
• Though Process Behind the Rule: Rule 11UA utilises cost approach as part of the building blocks of the rule-based method. The value derived based on cost approaches typically fall in the lowest levels of the value as compared to the market and income approaches. The Legislature in its prudence possibly thought of subverting the inadequate consideration transactions by testing the transaction value against the book net asset value. However, what is perhaps missed out was addressing the change in corporate law which had an allowance for flexible capital structure.

Conclusion:

DVR Shares may be used by the promoters to raise funds from other investors without the fear of losing control over the business decisions. It will prevent promoters and major shareholders from the dilution of shareholdings and hostile takeovers which will also benefit to the minority shareholders who are not interested in voting rights and are satisfied with other rights involved into bonus issues, dividends, ESOPs etc. However, the question that how significant and effective the DVR Share structure proves to be in this struggle for power between the promoters and the investors, that only time will tell.